ISSN 0956-8549-635 Lessons from the global financial crisis for regulators and supervisors Willem H. Buiter DISCUSSION PAPER NO 635 DISCUSSION PAPER SERIES July 2009 Willem Buiter has taught at Princeton University, the University of Bristol, the London School of Economics, Yale University and Cambridge University. He was an external member of the monetary policy committee of the Bank of England from 1997 till 2000. From 2000 till 2005 he was Chief Economist and Special Counsellor to the President of the European Bank for Reconstruction and Development. He has been an advisor to and consultant for the International Monetary Fund, the World Bank, the InterAmerican Development Bank, the European Commission and a number of national governments and private financial enterprises. Any opinions expressed here are those of the authors and not necessarily those of the FMG. The research findings reported in this paper are the result of the independent research of the authors and do not necessarily reflect the views of the LSE. Lessons from the global financial crisis for regulators and supervisors Willem H. Buiter* Professor of European Political Economy European Institute, London School of Economics and Political Science, CEPR and NBER June 13, 2009 *Paper presented at the 25th anniversary Workshop " The Global Financial Crisis: Lessons and Outlook" of the Advanced Studies Program of the IFW, Kiel on May 8/9, 2009. It develops ideas first discussed in my Den Uyl Lecture (Buiter (2008)), Abstract This lecture is a tour d’horizon of the financial crisis aimed at extracting lessons for future financial regulation. It combines normative recommendations based on conventional welfare economics with positive assessments of the kind of measures likely to be adopted based on political economy considerations. 2 Introduction “Never waste a crisis. It can be turned to joyful transformation”. This statement is attributed to Rahm Emanuel, US President Barack Obama’s White House Chief of Staff. Other versions are in circulation also, including “Never waste a good crisis”, attributed to US Secretary of State Hilary Clinton. The statement actually goes back at least to that fount of cynical wisdom, fifteenth century Florentine writer and statesman Niccolo Machiavelli “Never waste the opportunities offered by a good crisis.” Crises offer unrivalled opportunities for accelerated learning. I believe that the current crisis teaches us two key lessons. The first concerns the role of the state in the financial intermediation process and in the maintenance of financial stability. The second concerns the role of private and public sector incentives in the design of regulation. Unless these lessons are learnt, not only will the current crisis last longer than necessary, but the next big crisis, following the current spectacular example of market failure, will be a crisis of state 'overreach' and of government failure. Central planning failed and collapsed spectacularly in Central and Eastern Europe and the former Soviet Union. Stultifying state capitalism, initiative-numbing over-regulation and overambitious social engineering may well be the defining features of the next socio-economic system to fail after the collapse of the Thatcher-Reagan model currently under way – the chimera of self- regulating market capitalism with finance in the driver's seat – finance as the master of the real economy rather than its servant. 1. The essence of the current crisis This lecture focuses on the lessons for financial regulators and supervisors of the financial crisis that started around the middle of 2007 and the global contraction in economic activity that 1 resulted from it. It does not address the macroeconomic imbalances and anomalies that were important contributors to both financial crisis and economic slump. The five most important of these will be referenced briefly. 1. The ex-ante global saving glut that resulted from the emergence of the BRICs and the redistribution of global wealth and income towards the Gulf states caused by the rise in oil and gas prices. This depressed long-term global real interest rates to unprecedentedly low levels (see Bernanke (2005)). 2. The extraordinary preference among the nouveaux-riches countries (BRICS and GCC countries) for building up huge foreign exchange reserves (overwhelmingly in US dollars) and for allocating their financial portfolios overwhelmingly towards the safest financial securities, especially US Treasury bonds. This increase in the demand for high-grade, safe financial assets was not met by a matching increase in the supply of safe financial assets. This further depressed long-term risk- free interest rates (see Caballero (2006)). Western banks and investors of all kinds who had target or hurdle rates of return that were no longer achievable by investing in conventional safe instruments, began to scout around for alternative, higher-yielding financial investment opportunities – the search for yield or for ‘pure alpha’, which, as everyone knows, is doomed to failure in the aggregate. 3. Following the entry of China, India, Vietnam and other labour-rich but capital-scarce countries into the global economy, the return to physical capital formation everywhere was lifted significantly. The share of profits rose almost everywhere (see Broadbent and Daly (2009)). 4. Following the collapse of the tech bubble in late 2000 – early 2001, monetary policy in the US and, to a lesser extent also in the Euro Area, was too expansionary for too long starting around 2003, flooding the world with excess liquidity. For reasons not yet well understood, this excess liquidity went primarily into credit growth and asset price booms and bubbles, rather than into consumer price inflation. 5. The unsustainable current account deficit of the US was made to appear sustainable through the willingness of China and many other emerging markets to accumulate large stocks of US dollars, both as official foreign exchange reserves – it helps to be the issuer of the dominant global reserve 2 currency – and for portfolio investment purposes. A fair number of countries that continued to peg to the US dollar (or to shadow the US dollar) experienced excessive domestic liquidity and credit creation, contributing to asset booms and bubbles. China and the GCC countries are notable examples of this dysfunctional new ‘Bretton Woods’ (see Dooley, Folkerts-Landau and Garber (2004)). These five developments, plus the many regulatory and supervisory failures outlined below, created the Great Moderation, Great Stability or Mervyn King’s ‘Nice Decade’: high and reasonably stable growth, low and reasonably stable inflation, high profits, steadily rising prices of ‘outside’ assets and extraordinarily low risk spreads of all kinds (see Buiter (2007, 2009), King (2004), Bernanke (2004), Lomax (2007)). This Great Stability carried the seeds of its own destruction: as analysed and predicted by Hyman Minsky, stability bred complacency, excessive risk taking and, ultimately, instability (Minsky (1986, 2008)). The current financial crisis and the economic slump it caused arrived on the European continent about a year after it hit the US and half a year after it impacted the UK. It is the once-in-a-lifetime event that even the younger members of the audience will be boring their grandchildren with in the future. “You may think the financial turmoil and recession of 2034 is bad, but I can assure you that it is nothing like what we went through in the final years of the first decade of this century: the Great De-financialisation Crisis or the Great Deleveraging.” It started as a crisis in the financial system, became a crisis of the financial system and has now reached the point at which most of the western crossborder financial system of the past 30 years has effectively been destroyed and the remnants socialised or put in a state of subsidized limbo. It is correct but unhelpful to characterise the crisis as the result of greed and excess or as a crisis of capitalism. Greed has always been with us and always will be. Greed can be constrained and need not lead to excess. Excess is just another word for greed combined with wrong incentives and defective regulation and supervision. 3 The current crisis is not a crisis of 'capitalism', defined as an economic system characterised by private ownership of most of the means of production, distribution and exchange, reliance on the profit motive and self-enrichment (i.e. greed) as the main incentive in economic decisions, and reliance on markets as the main co-ordination mechanism. Capitalism has not always been with us, but is infinitely adaptable and will be with us for a long time to come. The crisis is a crisis of a specific manifestation of financial capitalism – a largely self- regulating version of the transactions-oriented model of financial intermediation (TOM) over the relationships-oriented model of financial intermediation (ROM). Every real-world financial system is a convex combination of the TOM and the ROM. In the north-Atlantic region, and especially in the USA and the UK, the TOM model became too dominant. This error will be corrected and the world will move towards a greater emphasis on ROM. But financial capitalism will be with us in a new phenotype, for a long time yet. I.1 A de-financialisation crisis The financial sector is a critical component of a decentralised market economy. It permits the saving decisions of individuals, institutions and other economic entities to be decoupled from their investment decisions.